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Santos has bought in Malaysian giant Petronas as a partner in the project. Petronas paid a total of $2.5bn for a 40% stake, valuing GLNG at $6.25bn and Santos's share at $3.75bn. Petronas operates the largest LNG plant in Asia and the world's largest fleet of tankers so the joint venture no longer lacks for technical ability.

WARNING This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary. Not all investments are appropriate for all people.

DISCLAIMER This publication has been prepared from a wide variety of sources, which The Intelligent Investor Publishing Pty Ltd, to the best of its knowledge and belief, considers accurate. You should make your own enquiries about the investments and we strongly suggest you seek advice before acting upon any recommendation.

QBE thrives in GFC It’s been a tough year for insurance businesses around the globe. But QBE has gone from strength to strength. Had you invested $10,000 in QBE Insurance 30 years ago, today your investment would have grown to more than $1.7m. And the mailman would also be stuffing nearly $100,000 worth of dividend cheques into your letterbox each year, an amount ten times your original investment. But to boast such a daunting track record and become one of the top 25 insurers and reinsurers worldwide requires a little luck and a lot of good management. One can trace QBE’s roots back more than 120 years, but its recent success is synonymous with current chief executive, Frank O’Halloran. His career at QBE stretches over 33 years and is typical of the long tenure of QBE’s top brass, including chief operating officer Vince McLenaghan, for example, who has spent 26 of his 50 years on the planet climbing QBE’s executive ranks. Such seasoned management is rare in today’s world of rolling three-year executive contracts, as is management’s relatively large stake in the business, as we’ll discuss shortly. But why has QBE been so successful?

QBE INSURANCE | qbe $23.34

Price at review

15 Dec 09

Review date

$23.3bn

Market Cap.

$15.01–$26.66

12 mth price range

2.5

Fundamental risk

3.5

Share price risk

LONG TERM BUY

Our view

Vital ingredients There are three ingredients to an insurance business’s profitability: underlying insurance profitability, investment returns on policyholders’ funds, and investment returns on shareholders’ funds. The underlying insurance profitability depends on the amount of premiums received and the combined operating ratio—a crucial yardstick for any insurance business. This ratio represents the percentage of revenue (or premiums) that is paid out in claims and operating expenses in any given period. For the year to 31 December 2008 (QBE has a December financial year end), QBE earned $11.1bn in insurance premiums. Of that, it paid out $6.4bn in claims and $3.4bn in operating expenses. Its combined operating ratio was, therefore, 88% ($9.8bn of expenses and claims on $11.1bn of revenue). An alternative way of thinking of it is that QBE ended up with $12 of ‘underwriting profit’ for every $100 of premium it collected, after associated expenses, making it one of the world’s most profitable insurance companies. Not all insurance businesses are so fortunate. It’s not uncommon for insurance companies to have combined operating ratios in excess of 100%—meaning they pay out more in claims and expenses than they collect in premiums. In the year to 30 June 2009, IAG’s combined operating ratio was 104%. And in the 1990s, QBE only once managed a combined operating ratio below 100% (99.8% in 1997). Making money with your money An insurance company producing losses from its underwriting operations can still turn a profit, though. It does this by investing the premiums it collects, or ‘float’, prior to paying out claims. In other words, QBE invests its customers’ insurance premiums and keeps the profit. In addition, QBE invests the pool of capital that it’s compelled to hold by regulators as further protection against catastrophic claims that could threaten the business (such as those linked to the September 11 US terrorist attacks). However, QBE’s expertise is in writing profitable insurance contracts. Its managers know this, they know they’re good at it and they take as little risk as possible when investing its float. The company had less than 7% of its $25bn investment portfolio in equities at the start of the bear market and most of the rest invested in cash and short-term, highly rated debt securities. Losses on its equity portfolio still

QBE’s combined operating ratio (%) 120 100 80 60 40 20 0

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‘QBE’s expertise is in writing profitable insurance contracts. Its managers know this, they know they’re good at it and they take as little risk as possible when investing its float. ’

totalled $554m last year, but QBE is in remarkably good shape after the most tumultuous year for financial markets in living memory. This conservative approach is also the main reason investors are panicking about QBE’s profitability. Returns on its portfolio are closely linked to cash rates around the world and these have been plummeting as the world’s governments prime the monetary pumps; unlike mortgage holders, QBE shareholders have billions of reasons to cheer for higher interest rates. QBE prices its competitive advantage Insurance is a commoditised industry, where most customers shop for the lowest price they can find. This might imply that QBE lacks a competitive ‘moat’, but its track record suggests otherwise. In fact, QBE has something that’s extremely valuable in the insurance business, something rare and that barely rates a mention in the textbooks: a culture of discipline. In the insurance game, it’s the policies that you don’t write that keep you profitable over long periods. We’ve spoken to a number of insurance professionals and the scuttlebutt is unanimous. If a deal doesn’t make sense, or a market is overrun with competition, QBE walks away. If that means losing a long-term client, so be it. It sounds obvious. No insurance company intentionally writes business that doesn’t make sense. But there are plenty of incentives for individual employees to write business aggressively. Try convincing an insurance company salesman to walk away from a contract for the sake of a 10% price reduction when his end-of-year bonus depends on how much premium he writes. It’s taken decades but, with a stable management team and substantial staff share ownership, QBE has convinced its staff that the long-term profitability of the business is far more important than any one year’s premium income. Consider the table below. QBE’s team of shareholders

Chief Executive Officer

Year to 31 Dec

11.1

13.3

Claims ratio (%)

55.8 54.3

57.6

60.0

Combined op. ratio (%)

85.3

85.9

88.5

89.0

1.5

1.9

1.9

2.3

EPS (c)

173

217

206

225

PER (x)

13

10

11

10

DPS (c)

95

122

126

128

Fkg (%)

60

55

20

20

4.3

5.5

5.7

5.8

NPAT ($bn)

33

Number of Current Ordinary value QBE shares ($m)

1,067,991

23.3

Chief Financial Officer

17

223,796

4.9

Vince McLenahan

Chief Operating Officer

26

185,657

4.0

CEO Europe

11

76,142

1.7

$35

CEO Asia

5

11,280

0.2

$30

CEO Australia

16

20,183

0.4

Michael Goodwin Terry Ibbotson

8.1

2009E

10.2

Neil Drabsch

Steven Burns

2006A 2007A 2008A

Net earned PREM. ($bn)

Yield (%)

Years Executive Role at QBE

Frank O’Halloran

Financials

QBE: 10-year price chart

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The majority of these senior executives have been with QBE for more than 15 years. They own a lot of shares and, in most cases, their investment is worth substantially more than their salary. This team genuinely wants shareholders to do well and they have a great track record of making it happen. ‘Our people are our biggest asset’ is the type of corporate guff that fills glossy annual reports. However it rarely rings true in practice and, even when it does, it’s often ephemeral—today’s corporate genius is too often tomorrow’s fallen angel.

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QBE priced for stormy weather QBE’s current share price doesn’t contain too much blue sky. If QBE turns out to be a run-of-the-mill insurance business, shareholders should still earn a reasonable return. We also believe this business has a culture that is nigh on irreplaceable and, if it can mimic the returns it has made in the past, the share price in 2020 will be multiples of what it is today. QBE is the kind of well-managed, home-grown success story we love to back. The dividend yield, though mostly unfranked, is a rather attractive

5.4%. And if you don’t already own QBE Insurance, now is a good time to start building a stake in the kind of neglected gem those with a long-term focus should consider as a cornerstone holding in a diversified portfolio. If the share price falls further, we’ll likely consider it an opportunity to load up on one of Australia’s best businesses. LONG TERM BUY.

Slow and steady wins for Westfield Westfield has earned its reputation as the ‘best in the business’. Though billion-dollar losses blemished its scorecard in 2009, its competitive advantage remains firmly intact. When Frank Lowy emmigrated to Australia following the Second World War, there wasn’t a single shopping centre in the country. In 1959, however, that changed with Westfield’s first development located in Sydney’s Blacktown. ‘Westfield Place’ comprised a dozen shops, a department store and one supermarket, and was the first major step on Lowy’s way to creating a global empire. Since then, Westfield’s bread and butter has been developing increasingly larger and more innovative shopping centres, often clustered in key geographic locations, such as Sydney and Melbourne in Australia, and California in the US. Westfield’s irreplaceable basket of shopping centres, currently valued at $48bn, accommodates more than 500m visitors each year, and cover 10.5msqm of floor space, a larger footprint than Sydney’s entire CBD.

Westfield’s business As a retail landlord, Westfield’s revenue depends on keeping its shopping centres busy and fully leased, and charging retail tenants as much as it can get away with. On this score, Westfield has been a runaway success. In Australia and New Zealand, anchor tenants such as David Jones and Woolworths, occupy 57% of Westfield’s floor space. They provide steady foot traffic for specialty retailers, such as women’s fashion chain Noni B and video game seller EB Games, who fight over the remaining 43%. Though floor space is split relatively evenly, on average, specialty retailers pay an incredible six times more rent per square metre than their anchor counterparts, and contribute 83% of Westfield’s Australasian revenue. Not surprisingly, though, during a downturn those specialty retailers tend to vacate space much faster than anchor tenants. Westfield occupancy turns up The recent downturn has been relatively mild in Australia and New Zealand, where Westfield’s shopping centres remain virtually full (greater than 99.5% occupancy). In contrast, occupancy rates in the US and UK stand at 92.1% and 97.8%, respectively, though occupancy has been rising slightly in recent months. To combat falling occupancy offshore, Westfield has offered retailers higher incentives. These include complimentary store fit outs and two-year leases (specialty leases normally stretch between three and five years). As those leases expire, Westfield aims to sign longer leases at higher rents; success will largely be governed by the strength of the global economic recovery.

Westfield’s costs, however, are relatively fixed. For example, a building manager needs to be employed whether a shopping centre is 99% or 45% occupied. So if revenue turns down, profit margins get crunched, along with the free cash flow available for distribution. That’s another reason Westfield is signing short leases; better to have a tenant paying lower rent than watch your centre become a ghost town. Stunted development Westfield has postponed new developments and acquisitions to keep a lid on its debt level and remain in favour with edgy lenders, but major works already in progress in London and Sydney are of the highest quality. Westfield’s developments are increasingly being integrated into hectic transport hubs, such as Sydney’s Bondi Junction. This guarantees a steady stream of shoppers and reduces the risk of obsolescence, which has affected regional centres in America as shoppers head to larger malls. Such integrated developments also demonstrate the skill of Westfield’s in-house design and development team. This group also has a talent for cutting through red tape which, constrained by geography and generally unfriendly local authorities, is a major obstacle in big urban centres. Those who can safely negotiate the minefield find a big prize at the end: a city centre location with limited competition. Westfield does it better than anyone, and this is a most crucial competitive advantage. Further, tight credit is warding off potential competing developments, although credit markets are clearly thawing out and property developers are ready to break ground.

‘Westfield has postponed new developments and acquisitions to keep a lid on its debt level and remain in favour with edgy lenders, but major works already in progress in London and Sydney are of the highest quality.’

Westfield caught off guard Ordinarily in a downturn, Westfield would be pecking at the portfolios of desperate sellers like a vulture. Unlike most of his contemporaries, executive chairman Frank Lowy had the foresight to raise billions in new equity and asset sales while the property market was running hot. However, it wasn’t enough. ‘Last year it was too murky; it was pull the shutters down and into the bunker,’ Lowy told The Australian Financial Review. Despite ‘signs of stabilisation and recovery’, acquisitions are on hold until conditions are ‘more stable and looking upwards’. So far high leverage has relegated Westfield to the unfamiliar role of spectator, but we wouldn’t rule out acquisitions if the global economy and credit markets keep healing—though Lowy would also likely then be forced to pay higher prices. With so many demands on the group’s finances, a major capital raising would likely precede any acquisition. And given management’s track record, we’d likely support any proposed deal. A raising would also help insulate Westfield from further property losses, higher vacancies and lower rents, and would put the group in a stronger position to fund developments or pick up individual gems from distressed sellers’ portfolios. The result, which we’d be prepared to stomach, would be lower distributions in the short term; a case of pain today, gain tomorrow. Is Westfield cheap? That Westfield’s developments are growing larger and more bold is also a sign that Frank Lowy’s masterpiece remains a work in progress. When he eventually decides to hang up his hard hat, his three sons David, Peter and Steven—accomplished Westfield executives in their own right—will ensure the company remains in safe hands. This provides a degree of comfort, but is the stock price cheap enough to buy? Westfield is trading on an 7.8% forecast yield for 2009. However, management will slash distributions from August 2010 by around 20% to 25%, which means future returns will be knitted tightly to development

profits. If you’re solely focused on income, you might steer clear or wait for a lower price. Westfield also trades at a premium to its net tangible assets (NTA) per security of $11.02. Though we’d prefer to buy at a discount, we’re prepared to pay a premium given that current large developments should add significant value on completion. And, although it’s difficult to assign a specific dollar value, the Lowy family’s experience and track record also represent a genuine ‘intangible asset’. Top gear Investors are sceptical of Westfield’s prospects in a world of lower leverage and growth, but this industry stalwart is a bit like a Ferrari stuck in traffic. Though the economic downturn and tight credit conditions have constrained Westfield’s short term performance, once the pall of depressing economic traffic eventually gives way to open road, Westfield’s performance should hit top gear. There’s no need to dive in with both feet, though. Being patient and slowly building a stake over time will allow you to take advantage of potentially lower prices or any capital raisings. Westfield may not be as hot a topic at dinner parties as the latest market darling, but that’s one more reason why investors who prefer to own the very best should put it on the menu. Westfield is a classic LONG TERM BUY.

Recommendation guide Buy Long Term Buy

Below $10.50 Up to $13.00

Hold

Up to $16.00

Take Part Profits

Up to $18.00

Sell

Above $21.00

Time to buy Aristocrat Aristocrat’s worry list could fill an entire exercise book, but that’s the best time to buy if you’re betting on a future recovery. Len Ainsworth quit medical school to join his father’s dental equipment manufacturing business in the 1940s. Following an engineer’s suggestion that the factory’s equipment could be converted to build poker machines, ‘The Clubman’ rolled off the production line in 1956; reputedly the first poker machine to offer multi-line and scattered payouts. It also signalled the embryonic arrival of what was to become the world’s largest pokie manufacturer, Aristocrat Leisure. The Clubman precipitated a long line of firsts for Aristocrat, which included pioneering video games that rendered mechanical reels and levers obsolete (though ‘stepper’ games are still popular in the US). More recently, sophisticated technology has linked machines both within and without venues to offer higher jackpots, and Aristocrat has been adept at catering to slot players favouring small denominations; a trend that has accelerated during the downturn. Aristocrat isn’t limited to simply selling gaming machines, either. It also provides monitoring and control systems for clubs, pubs and casinos, offers consulting services and increasingly leases its machines to operators (primarily in the US, though, as the practice is illegal in Australia).

Aristocrat hit the jackpot when it received approval to manufacture, sell and operate gaming machines in the world’s two largest pokie markets, Japan and Nevada (home to sin city, Las Vegas). In 2005, Aristocrat’s skill negotiating with foreign regulators and developing games for foreign markets led to deals in Russia and Macau, where it enjoys a 60% market share. But despite Aristocrat’s competitive advantages, which include a strong position in a high growth, global industry that’s protected by regulation, the company has been plagued by crises in the corporate suite.

ALL: 10-year price chart $20

Trouble at the top After being diagnosed with cancer in 1994, Ainsworth split the company between his seven sons before it listed on the Australian Stock Exchange in 1996. Later, in 2003, then CEO Des Randall was shown the door in a cloud of controversy, which included a Columbian company receiving a large order but failing to pay. Paul Oneile, another external appointment, then assumed the reins and appeared to right the ship, together with chief financial officer Simon Kelly, who was appointed around the same time. Prior to the recent global downturn, Oneile and Kelly produced a jackpot performance; annual total shareholder returns (capital gains plus dividends) between 2003 and 2007 were 77% and the stock practically ten-bagged. But when the economy turned up lemons and oranges (pardon the pokie gag—Ed) , Aristocrat malfunctioned and Oneile resigned. The share price currently languishes 78% below its February 2007 all-time high of $17.68. Not having groomed a successor, Oneile’s retirement in 2008 perpetuated a regular company weakness; once again Aristocrat was forced to poach a CEO. Jamie Odell, a former Foster’s executive, who has no experience at the helm of a public company, is currently charged with turning around the company’s fortunes. Against the current economic and competitive backdrop, that won’t be easy. Strong headwinds Aristocrat’s latest game releases have faced strong headwinds at home and overseas, as dwindling gambling profits and tight credit squeeze pokie operators. While Aristocrat has been distracted, its two smaller (but growing) rivals, WMS Industries and Bally Technologies, have reported record profits, with WMS Industries announcing plans to expand in Australia. This is particularly concerning, given the huge increase in popularity of its games in the US and abroad. But despite Aristocrat’s extensive laundry list, there are reasons for optimism. Barriers to entry in this highly lucrative industry remain high; Aristocrat’s games satisfy regulations across 162 jurisdictions. Together with the incumbents’ scale, it’s a formidable hurdle for new entrants. The current glacial speed of replacement sales in Australia implies games will survive 35 years; a rather unrealistic assumption which points to a future bump in replacement sales at some point. The same figure has reached an historic 18.5 years in the US. Ultimately the replacement cycle will turn, providing a wave of demand for the latest innovative games. Playing to its strengths Odell is also focusing Aristocrat on its most profitable markets. The US and Japanese markets harbour higher growth potential than the mature Australian market, and US states previously prudish toward poker machines might have a change of heart given the poor shape of their finances. Aristocrat will also withdraw from 30 jurisdictions within the next year, which should boost margins. We’re also cognisant of the fact that Aristocrat is a turnaround situation, which sometimes don’t turn as expected. However, its finances are healthy

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‘Barriers to entry in this highly lucrative industry remain high; Aristocrat’s games satisfy regulations across 162 jurisdictions. Together with the incumbents’ scale, it’s a formidable hurdle for new entrants.’

and it’s remained profitable throughout the downturn. Odell has wiped the slate clean of lousy investments and legal action. And poker machine manufacturers protected by regulation tend to be high quality, durable businesses. Aristocrat has a history of surviving mismanagement and emerging from each episode bigger, stronger and more resilient than before. We’re betting it will eventually prosper again. Jackpot or jinxed? Though Aristocrat’s forecast PER (approaching 20) doesn’t look cheap, if we’re at or near a nadir in the cycle and Odell can right the ship, then the current price will look like a steal in hindsight. Tempering our enthusiasm, though, is that it’s difficult to distinguish whether Aristocrat’s brand has taken a mortal hit over the past couple of years, or whether its poor performance is merely a reflection of a deep cyclical downturn compounded by poor management. If it’s the latter, then those who have the courage to buy shares today and exercise patience tomorrow should eventually be rewarded. If it’s the former, and WMS and Bally have stolen an irreversible march on Aristocrat during the downturn, then we’re comforted by the fact that Aristocrat has remained profitable despite all the recent cards falling unfavourably. If you only invest in companies with experienced management teams boasting a sound track record, then you might give Aristocrat the same wide berth our team give its products, or wait for a lower price. Though we prefer backing proven managers, Odell doesn’t need to be a genius to turn one of Australia’s highest quality businesses around. Down on its luck We love buying good businesses when they’re down on their luck and Aristocrat is currently on the nose with many investors. If the stock already represents more than 5% of your portfolio, we don’t recommend increasing your stake at this stage. But if you’re looking to string together a portfolio of high quality blue chip stocks, then Aristocrat certainly demands some attention. Unfortunately, it has a history of producing nasty surprises and every time you think things couldn’t get worse, a financially painful revelation seems to spring forth. But for long-term investors, these are the types of opportunities that can add enormous value to your portfolio if a few things go right. We don’t recommend you jump in with both feet at the current price but Aristocrat is an attractive LONG TERM BUY.

it of e spir In th son we’ve a tra the se ded an ex u l inc k review stoc Santos used to be seen as the cardigan

Santos steps on the gas

wearing gas producer. Not anymore.

Santos toiled for 10 profitless years before discovering gas in South Australia’s Cooper Basin in 1963. But it wasn’t until the larger Moomba gas discovery in 1966 that the Cooper Basin really proved itself as a prolific hydrocarbon province. By the 1980s Santos had signed key supply contracts with utilities in SA and NSW. During the 1990s when oil was considered ‘old economy’, Santos’s pursuit of acquisitions gave it a presence around the world. Today it is the second largest specialist oil and gas producer in Australia. Despite the company’s growth, the 40-year old Cooper Basin remains a key asset. During the 1990s, the basin had grown to account for 95% of Santos’s 2P (proven and probable) reserves. The region’s production and cash flow was so consistent that Santos was increasingly viewed as a low growth utility rather than a risky oil and gas company. In 2009, many investors still view Santos as the cardigan-wearing custodian of the Cooper Basin. But it’s been quietly accumulating assets and reserves; the Cooper Basin now accounts for only 18% of its 2P reserves (see chart). Last year the company added 280 mmboe (million barrels of oil equivalent) to its assets, which increased its total 2P reserves to just over a billion boe. Although most of that growth came from new assets, Santos continues to extract value from its heroic legacy asset. Cooper Basin blues Cooper Basin production and long term sale contracts have allowed Santos to pay a dividend every year since 1978. There is one problem, however; after more than 40 years of production, the Cooper Basin may be in decline. Santos is adamant that another 40 years of production remain. Where will this come from? Management has cryptically stated that the Cooper Basin ‘looks like the Barnett Formation in Texas’. From this hint, we suspect they mean that additional production will come from unconventional gas. The Barnett Formation, thought to be the largest accumulation of gas onshore USA, is unique because gas is trapped within low permeable rocks. In the jargon, the gas is ‘tight’ and requires some technological coaxing to flow. This can be done, but requires a high level of technical skill; stimulate the rocks too much and the reservoir will be ruined. But the technology to extract such resources is improving every year, while the cost continues to fall. Massive amounts of gas have been recovered in the US so far by extracting unconventional reserves, and that quantity is increasing. Even ExxonMobil, the world’s largest publicly listed oil and gas firm, has been converted towards the merits of the new resource. It recently bid $33bn to acquire XTO, a US specialist in unconventional gas extraction. Santos intends to use new technologies learned from unconventional oil science to not only maintain the Cooper Basin’s production but increase it. New rigs, for example, can drill multiple holes from a single point, thereby increasing the gas output from each well. There is evidence that the company’s investments are paying off. Since 2002, Santos has enjoyed a 92% success rate for appraisal wells and a very respectable 51% success rate for exploration wells in the region. Typical success rates in the oil and gas business are about 10%. The discount that has been applied to the stock to reflect the maturity of this asset may no longer be warranted. The company is also showing that it can grow reserves via the drill bit. The Mutineer-Exeter field offshore Western Australia (Santos’s share is 33%)

is of particular importance because future liquids growth will more likely come offshore. Developing experience and expertise in offshore production is extremely important. The project, which began in 2005, marks Santos’s first foray into operating an offshore field. By contrast, Woodside began operating the North West Shelf back in 1983. LNG the wave of the future Most of the growth in Santos’s total reserves, and much of its future production, will come from LNG (liquefied natural gas). LNG refers to the process of turning gas into a liquid, a process known as liquefaction. In liquid form, LNG fills just 1/600th of the space that it does in its gaseous state. That makes the economics of transportation, particularly by sea, much more attractive. One tanker of LNG, for example, can supply 40% of Japan’s daily energy needs (for a more local example, you could leave the lights on at the MCG for 20 years with the energy from that same tanker). At the end of its journey to Japan or elsewhere, the liquid is turned back into gas in a process known as regasification, for distribution via domestic pipelines. LNG does two important things for the gas market. Firstly, it improves the economics of gas production by allowing producers to access markets with higher gas prices. Qatar has recently been diverting LNG sales to Asia rather than the EU for this very reason. Secondly, it makes previously ‘stranded’ gas fields—those that were too remote from customers to utilise pipe infrastructure—viable. Gas can simply be transported as LNG. Santos has three LNG projects. It’s already a partner in the Darwin LNG joint venture, which has been exporting LNG to Japan since 2006. It also has a 13.5% stake in PNG LNG, a large project that was recently sanctioned by operator ExxonMobil. But the most ambitious and significant project for Santos is Gladstone LNG (GLNG), based in Queensland. From coal to gas Before we look into the project that is causing all the excitement, here’s a crash course in coal seam gas, or CSG as it’s known in Australia. CSG turns out to be methane, the same end product as conventional gas. The difference lies in the method of extraction. Just as conventional gas is trapped by rocks, CSG is trapped by pressure and water within coal. To get the gas to surface, water has to be extracted from the coal seam, which reduces pressure to release the gas. But CSG has two major pitfalls. One is that extracted gas has to be processed on site and separated from water. More importantly, however, a lot of holes need to be drilled to get a commercial rate of flow. So CSG is a highcost business, which adds an element of risk. Gladstone LNG will involve significant capital expenditure. Gas has to be extracted, processed and then piped 450km to Curtis Island, where Santos will construct a plant to convert gas to LNG. A lot of money, about $8bn, will be spent on all of these activities. And we suspect the final cost may be considerably above budget. Critics of CSG—and there are many—argue that the cost differential between CSG and conventional LNG are large enough to cast doubt on the viability of the CSG industry. While cost differentials are real, both new technology and higher gas prices have made CSG production commercially viable. CSG currently supplies 85% of Queensland’s natural gas market. Santos has bought in Malaysian giant Petronas as a partner in the project. Petronas paid a total of $2.5bn for a 40% stake, valuing GLNG at $6.25bn and Santos’s share at $3.75bn. Petronas operates the largest LNG plant in Asia and the world’s largest fleet of tankers so the joint venture no longer lacks for technical ability. An investment decision is due during 2010 and sales agreements are already being sought.

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‘Most of the growth in Santos’s total reserves, and much of its future production, will come from LNG (liquefied natural gas).’

One company, two values There are two broad methods we can adopt when valuing resource companies. One is to look at an earnings based measure, such as PER or EBIT multiples. Another method is to look at resource based measures, such as the enterprise value to 2P reserves ratio (EV/2P). Both methods are imperfect. Relying on earnings alone only tells us about the present and takes no account of changes to production. Resource-based measures tend to value producing and in-ground reserves equally, which is also misleading. With that in mind, we caution that valuations for resource businesses are tricky and need some qualitative interpretation. Nevertheless, we have included our estimated valuation in the table to the right. In the ‘high’ range, we include an EBIT multiple of 10 for the base business. Underlying this are assumptions that the oil price continues to rise and production is sustainable for another 40 years. We apply Petronas’s GLNG transaction in full and value estimated PNG LNG resources at $15 per barrel of oil equivalent. In the low range, the base business commands an EBIT multiple of 6, the Petronas valuation is discounted 20%, and PNG LNG is valued at $5 per boe. We place no value on riskier exploration ventures in Bangladesh and Vietnam. Santos has a market capitalisation of $11.8bn and net debt of $500m for an enterprise value of $11.3bn. When judged on an earnings basis, our indicative valuation puts Santos close to fair value, between our high and low valuations. On a reserves basis, however, Santos looks much cheaper, trading on an EV/2P of under $14. This figure needs to be treated with some caution, because about 40% of Santos’s reserves come from CSG, which is not as valuable as conventional gas or oil, so a discount should apply. Even so, Santos has additional contingent resources (see Shoptalk) of 2.8 billion boe, so we anticipate much more reserve growth to come, and that growth doesn’t seem to be reflected in the current share price. The difference between value on an earning basis and on a resource basis reveals an important trend. While it has added reserves over the last few years, Santos has yet to turn these additions into production. This is why the company appears fully priced on an earnings basis but cheap on a reserves basis. Santos can only be considered good value if we believe that the company’s reserve growth will result in production growth in the future. Following the deal with Petronas and a $3b capital raising, the company has a debt to equity ratio of just over 10%. Santos has also scaled back some of its drilling program this year as the oil price fell and we expect it will continue to adjust its capital program in response to the oil price. Funding commitments towards PNG LNG will be about $500m and in 2010 it will spend about $2bn on GLNG. It is possible that further down the track the company will require an equity raising to pay for the remainder of the GLNG start-up costs. Santos retains the largest exploration portfolio of any domestic oil and gas company and has been successful in adding reserves to its basket. We need to see more evidence that these will be turned into production growth before we can enthusiastically recommend the company as an outright Buy. But at current prices, the downside is limited and potential production growth has yet to be factored in. The company pays a dividend yield of about 3.1% which, with stable cash flows, should continue. We believe an opportunity exists to build a position in this high quality, relatively low risk oil and gas company. LONG TERM BUY.

and gas estimated to be recoverable from known accumulations. They are not currently considered commercially viable, often because of a lack of marketing, transport or other political or environmental obstacles.

Versatility: The larger your needs are, the more important it is that you work with a high-end printing company that has both expertise and experience. Everyone from non-profits to commercial enterprises send out large amounts of print each year. Fro

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